Company defaults headed for largest cyclical rise since recession

Financial stocks tend to underperform in lead-up to default cycles— just like they are right now

By

RachelKoning Beals

News editor

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There’s growing evidence that the U.S. is flirting with a spike in corporate debt defaults — ones that may not rewrite history but could stretch beyond the much-publicized troubles for energy companies, Deutsche Bank analysts said in a research report issued Monday.

Deutsche Bank concedes that the U.S. remains in a relatively low-default climate despite swimming in outstanding debt and feeling the drag of disappointing global economic growth. It’s that low-default climate that should keep the next cycle from jumping outside of the historical norm.

According to Deutsche Bank, it’s reasonable to expect non-commodity high-yield defaults [meaning, the riskiest of company bonds] on the lower side of the historical experience — at 4% one year from now. That’s well off the 12% to 15% hit during the worst default cycles of the past. Policy errors, or at worst, recession, could easily lift this number into the 8%-10% range and up to 12%-15% for companies with commodities exposure, including the highly vulnerable U.S.-based oil and gas concerns, they said in the report.

Moody’s Investors Service, out with its own updated snapshot of the high-yield, or speculative-grade, debt market, pegs the non-commodity default rate at 4.6% in one year, from the current level of 3.8%. In its note also released on Monday, Moody’s predicts that the speculative-grade default rate will reach 4.3% in the second quarter, surpassing its long-term average of 4.2% for the first time since August 2010.

“This reaffirms that the corporate default cycle has turned and that global defaults are clearly on the rising track,” Moody’s analysts agreed.

Default rates have been held down in part by a Treasury yield curve that hasn’t flattened enough to cause immediate alarm for sharply stricter lending standards, although standards are tightening. Indeed, 2015’s default rate for stronger credit single-B-rated company bonds rose to 2.7% from 0.9% a year earlier and was still lower than all of the first two decades of the modern era of leveraged finance up to 2003.

Deutsche bank’s U.S. strategists have said that a combination of three conditions is necessary to declare the next default cycle is imminent: the accumulation of excessive debt, especially of deteriorating quality; an external shock/trigger; and tighter monetary policy/flattening of yield curves.

“The pieces of the jigsaw are building,” the analysts said in their note. “U.S. corporate debt accumulation now compares with that seen prior to previous default cycles. Equity volatility has seen two spikes in the last year (in August and early 2016), bank equity is falling and the global yield curves continue to flatten.”

Banks could prove a telling area of change. U.S. financial equities have tended to underperform the S&P 500 by 15%-20% in the year leading up to the previous three default cycles in 1988-1990, 1997-2000, and 2006-2008.

“As we stand today they are underperforming the index by around 10% since reaching their recent peak level in Aug 2015. Within financials, U.S. banks are underperforming SPX by 19%. Importantly, both of these metrics are at the lows of their recent ranges, refusing to show any improvement alongside of a market rally that has taken place since early February 2016,” the U.S. team, led by Oleg Melentyev, said.

“The variable that perhaps is still offering some hope that a full cycle can be delayed is that the U.S. yield curve hasn’t yet flattened enough to provide a strong signal, even if it does suggest a continuing tightening of lending standards and rising defaults,” the analysts said.

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The difference between a 2-year Treasury yield and a 10-year Treasury yield is roughly one full percentage point. That’s a gap that would normally be considered a safe distance away from being completely flat, as it has been prior to cyclical turns in the past. But Deutsche Bank analysts think the unusual heavy-handedness of central banks is distorting that picture.

And it’s important to think of interest rate markets as global. “The fact that many other major country yield curves continue to flatten, and in many cases are getting close to flat, offsets some of the comfort from the U.S.,” they said. “Also complicating the matter is this era of heavy financial repression and very active central banks.” Both the European Central Bank and Japan have continued to make aggressive stimulus moves for their respective economies even while the U.S. maintains its intention to raise interest rates.

Looking back 80 years, virtually all recessions were preceded by a flattening curve without necessarily requiring an inversion, in which short-term rates are abnormally higher than their longer-term counterparts.

And corporate spreads to U.S. Treasurys are worth noting. The current level of net spread tightening, or the difference between yields paid on higher-risk corporate bonds and lower-risk government-backed bonds, is consistent with a U.S. default rate above 4.5% by the end of the year relative to 3.4% now and a long-term average of 4.3%, Deutsche Bank said. For now, they added, buy-and-hold investors are being adequately paid for added bond risk.

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